What is a Depression?

Before I try to explain what a Depression is, let me explain what a bubble is.  A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,  with the term of liabilities usually shorter than the lifespan of the asset class.

But, before I go any further, consider what I wrote in this vintage CC post:

David Merkel
Bubbling Over
1/21/05 4:38 PM ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:

1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?

This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.

To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.

Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.

It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.


Bubbles are primarily financing phenomena.  The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.  What’s the life span of an asset?  Usually quite long:

  • Stocks: forever
  • Preferred stocks: maturity date, if there is one.
  • Bonds: maturity date, unless there is an extension provision.
  • Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
  • Real Estate: practically forever, with maintenance.
  • Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.

Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.  The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.

But was this always so?  Let’s go back through history:

2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.  There was a tendency for more homeowners to finance short.  Investment banks rely on short dated “repo” finance.  Hedge funds typically finance short through their brokers.

1998-2000: Tech/Internet bubble.  Where’s the financing?  Vendor terms were typically short.  Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.  Also, equity capital was very easy to obtain for speculative ventures.

1998: Emerging Asia/Russia/LTCM.  LTCM financed through brokers, which is short-dated.  Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.  Debts in US Dollars, or other hard currencies are as bad as floating rate debt,  because in a crisis, it is costly to source hard currencies.

1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).  Mortgages?  As the Fed funds rates screamed higher, leveraged players were forced to bolt.  Self-reinforcing negative cycle ensues.

I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.  Consider this piece from the CC:

David Merkel
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis
  • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.  Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.  Yield spreads widen dramatically, and often financing cannot be obtained at all.  If a bubble is a type of “boom phase,” then its demise is a type of bust phase.

    Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.  As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.  Those parts with high yield spreads because of the bust do not get any benefit.

    But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?  That is a depression.  At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.  It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.

    Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.

    How does this end?

    It ends when we get total debt as a fraction of GDP down to 150% or so.  World War II did not end the Great Depression, and most of the things that Hoover and FDR did made the Depression longer and worse.  It ended because enough debts were paid off or forgiven.  At that point, normal lending could resume.

    We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.  It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)

    We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.  If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)

    We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.  In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.

    But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.  The proper investment actions here depend on what Government policy will be.  Will they inflate away  the problem?  Raise taxes dramatically?  Default internally?  Externally?  Both?

    I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.  One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.  But maybe gold and long nominal T-bonds is better.  Hard for me to say.  We are in uncharted waters, and most strategies do badly there.

    Last note: if you invest in stocks, emphasize the ability to self-finance.  Don’t buy companies that will need to raise capital for the next three years.